Momentum

Buy high, sell higher?

Financial markets will never be efficient because markets are, and will always be, driven by human emotions: greed and fear — Seth Klarman

One of the largest search parties on record was assembled in 1968, when the U.S. military lost a nuclear submarine named Scorpion after its tour in the North Atlantic. The situation was tense as not only was Scorpion powered by a nuclear reactor, it had two torpedos armed with a nuclear warhead.

Even though the Navy had the sub’s last known location, there was no way of knowing how far the sub might have gone before something happened. The final search area was a circle 20 miles wide and thousands of feet deep. Finding the sub using 1960s technology would be comparable to finding a needle in a haystack.

A naval officer named John Craven stepped up to the challenge with an unusual plan.

Instead of asking a few experts about the possible location of the sub, Craven consolidated a wide variety of scenarios on what could have happened to the Scorpion. He then assembled a group of men from varying fields like submarine specialists, mathematicians, physicists, oceanographers, and even salvage men. Then, instead of forming a team to brainstorm and discuss possible locations, he asked all of them individually to come up with their best guess on what happened to the sub and where the final location of the sub would be.

Craven believed that no one would have the right answer but if he took all the guesses and built a model, he would be able to estimate the location of the sub. And that’s exactly what he did — he took all the guesses and used Bayes’ theorem to estimate Scorpion’s final location. The location Craven came up with was not one picked by any of the members. Crudely put, it was decided by the collective wisdom of everyone in the group.

It took 5 months to find the wreckage of Scorpion, but when the navy ship finally found it, it was only 200 yards away from where Craven’s group had said it would be.

What’s astonishing about this story is that the evidence that the group was relying on in this case amounted to almost nothing. It was really just tiny scraps of data.

No one knew why the submarine sank, no one had any idea how fast it was traveling or how steeply it fell to the ocean floor. And yet even though no one in the group knew any of these things, the group as a whole knew them all. — James Surowiecki, (in his book, The Wisdom of Crowds)

Here is the kicker — Even after 55 years, we still don’t know what happened to Scorpion.

It’s a well-documented fact that under the right conditions, a large group of ordinary individuals can be smarter than an elite few. And there is one place where hundreds of thousands of people make a decision on a specific topic every day — The stock market.

Take Apple, for example: more than 50 million shares of Apple traded just last Friday. That’s thousands of individual investors and institutions making the decision to buy or sell Apple stock every day.

Similar to what Craven did, there is an interesting strategy that tries to leverage the collective wisdom of all investors in the market — Momentum investing.

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The Trend is Your Friend

The idea behind momentum investing is simple — Winners will continue to win and losers will continue to lose. Here’s a simple strategy to break down momentum investing¹.

1. You pick a stock universe — Let’s say the S&P 500.

2. Then you backtest and find the top 50 stocks (top 10 percentile) that had the most price appreciation over the last 6 months.

3. You buy and hold these 50 stocks for the next 1 year

4. At the end of the year, you sell all the stocks and start from step 1.

We are certain that our readers who lean towards the efficient market hypothesis and value investing will now be screaming in their heads. But, before you close the tab and leave, check out these stats:

• Return premium for momentum strategy is evident in 212 years of data² (Yup, that’s not a typo).

• Momentum trend has held in 40 different countries over 12 different asset classes³.

• From 1927 to 2009, momentum strategy has beaten the overall market 98% of the time over a rolling 10-year period — with a 4.26% average annual excess return.⁴

Let’s dig into why this simple strategy outperforms and how to get momentum exposure to our portfolios:

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